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Reduce tax rates to grow the economy and increase tax collections

It is well known that the growth of the South African economy is languishing, and that unemployment levels are dangerously high. Without real economic growth, it is unlikely that sufficient sustainable jobs will be created to reduce unemployment levels significantly Tax collections are also under pressure; a depressed economy means lower tax collections. With a ballooning government deficit, the Treasury is under pressure to collect more revenue to fund expenditure.

One could almost label our situation as desperate – and, as everyone knows, desperate times call for drastic measures.

So what possible drastic measures could be taken? How about cutting tax rates to increase economic growth and tax collections?

With the need to raise more revenue to fund a growing deficit, it seems counter-intuitive to reduce taxes to increase tax collections. But perhaps we should not be too quick to dismiss the idea.

Arthur Laffer, a well-known economist, is credited with conceptualising the so-called Laffer Curve, which is a graphical representation of the relationship between tax rates and tax collections. According to the Laffer Curve, as tax rates increase so do tax collections, but only to a certain point, after which as tax rates increase, tax collections actually decline. So when a country is on the declining part of the Curve, a tax rate cut will actually boost tax collections.

Laffer also showed through empirical evidence that his theory does work in practice as well – as tax rates were cut in the United States during certain periods in the last century, the effect was, after a short term decline in tax collections, to actually increase tax collections in the medium to long term. He also showed that the tax cut had a positive impact on economic growth and unemployment levels, which explains why tax collections increased over the medium to long term – even though tax rates had reduced, there was a larger base to collect taxes from.

An American commentator, Daniel J Mitchell, further postulates that governments should not set tax rates at the revenue maximising point, but rather should set tax rates at a point below the revenue maximising point, which would maximise economic growth instead. Higher economic growth presumably would lead to higher tax collections in the long term due to a growth in the underlying tax base.

In South Africa, researchers at the University of Pretoria showed, in 2008, that our tax rates are too high to support growth. Around that period tax collections as a percentage of GDP was 26%-28%, whereas the optimal growth maximising tax ratio was estimated to be 21.94%.

So how would reducing tax rates impact South Africa? In the short term tax collections are likely to decrease. But this could be offset in the medium term by increased levels of savings and investment, leading to higher economic growth and lower unemployment. There would also be less incentive to engage in tax arbitrage activities, tax evasion and aggressive avoidance schemes. Which could mean higher tax collections in the medium to long-term. Of course, the socialists amongst our society may not be happy with the idea that the rich potentially get to pay less tax.

Regardless of potential objections, it is hoped that the Davis Tax Review Committee at least consider this option – the objective of the commission is “to assess our tax policy framework and its role in supporting the objectives of inclusive growth, employment, development and fiscal sustainability”. If internationally there is evidence that reducing tax rates may impact positively on growth and unemployment, then this option should certainly not be ignored.

Speculation is rife that 26 February 2014 will see Pravin Gordhan reading his last Budget Speech as the Minister of Finance. As his swansong, reducing tax rates will certainly be an act that will leave a legacy.

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